Monday, May 31, 2010

A Word or Two From Adam Smith on Regulating Interest Rates

In a largely neglected topic discussed by Adam Smith (including by myself) I have found myself undecided about the merits of the arguments for and against his position (which itself is not very clear or decisive). I refer to the occasional laws introduced on usury and the long established theological prejudice against interest, still encountered in Islamic communities.

Wealth Of Nations discusses the subject in Books I and II. Smith noted how the ‘profits from stock’ rise or all in some relationship with the rate of interest (WN.I.ix.4: 105). Typically, Smith traces the historical record. Henry VIII passed a law declaring all interest above 10 per cent ‘unlawful’, while Edward I, from his ‘religious zeal’ prohibited all interest. Smith didn’t think much of this or its effect, which ‘probably increased rather than diminished the evil of usury’ (WN I.ix.5: 106). The editors of the Glasgow edition of WN append a footnote quoting Cantillon’s Essai (278-9, ed. Higgs, 211):

‘Nothing is more amusing than the multitude of Laws and Canons made in every age on the subject of the Interest of Money, always by Wiseacres who were hardly acquainted with Trade and always without effect.’

James VI and I (first King of Scotland and England) reduced it to 8 per cent (1623), Charles 1 to 6 per cent (1661) and Queen Anne to 5 per cent (1713). Smith remarks that these official maxima ‘seems to have followed’ the market rate of interest. He notes that before the ‘late war’ (1750) the government borrowed at 3 per cent rising to a peak of 4.5 per cent (1755).

Smith returns to the subject in Book II. The permitted rate tends to be related to its general market price available to ‘those who can give the most undoubted security’, and the anti-usury rate ought to be fixed somewhat above the market rate (if fixed below the market rate it would choke off lending and ruin ‘honest people’). He illustrates the British example where the rate of interest paid on government bonds was 3 percent, and private people with good security pay 4 to 4.5 per cent, with the legal rate (maximum) was 5 per cent, which was ‘perhaps as proper as any’ (WN II.iv.14: 357).

He further observed that if the legal maximum was ‘so high as eight or ten per cent’ then the ‘greater part of the money which was to be lent, would be lent to prodigals and projectors, who alone would be willing to give this high interest’, adding that ‘Sober people, who will give for the use of money no more than a part of what they are likely to make by the use of it, would not venture into the competition’. In consequence a ‘great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into those which are most likely to waste and destroy it’. Contra-wise, where the legal rate is fixed ‘but a little above the lowest market rate, the greater part of the ‘capital is thus thrown into the hands in which it is most likely to be employed with advantage’ (WN II.iv.15: 357).

This seems an eminently sound analysis, and typically Smithian in his ‘sober’ manner where pragmatic sense meets ideological purity, bearing in mind his many strictures against the role of ‘prodigals and projectors’, whose activities added to the flow of funds to wasteful prodigals (‘every prodigal appears to be a public enemy; WN II.iii.25: 340) or careless loss-making projectors (spenders on ‘injudicious and unsuccessful project[s]’; WN II.iii.26: 341) instead of putting to work productive labour which causes the resultant growth of national output.

Jeremy Bentham (Letter XIII, Defence of Usury), addressed to Smith objected, partly on the grounds that ‘such a regulation was a violation of Smith’s own principle of liberty, and partly on the ground that it would discourage those men of enterprise upon whom the economic process would depend’ (editors’ note: WN II.iv.15n 17; n 19: 357).

I do not regard Bentham’s criticism as decisive. Smith departed from the principle of liberty on several occasions – and quite rightly too. He was not an ideologue, which may disappoint several relatively uninformed readers of Smith and a few of those whose interpretations of Smith are based on their own ideological focus (of which a few Libertarians, though not all, i.e., those who live in the real world and who have a perspective of history short of the possibilities of an imaginary utopia, are wont to do).

Smith made several exceptions to ‘the liberty principle’ in banking (small denomination currency notes), in British trade (the Acts of Navigation), in tariffs (the need to fund government expenditure) and in safety (party walls to stop fire spreading).